HONG KONG (REUTERS) - Hong Kong called off talks with protesting students on Thursday, dealing a heavy blow to attempts to defuse a political crisis that has seen tens of thousands take to the streets to demand free elections and calling for leader Leung Chun-ying to resign.

The government's decision came as democratic lawmakers demanded anti-graft officers investigate a US$6.4 million (S$8 million) business payout to Leung while in office, as the political fallout from mass protests in the Chinese-controlled city spreads.

"Students' call for an expansion of an uncooperative movement has shaken the trust of the basis of our talks and it will be impossible to have a constructive dialogue," Chief Secretary Carrie Lam said on the eve of the planned dialogue.

She blamed the pull-out on students' unswerving demands for universal suffrage, which she said was not in accordance with the Asian financial centre's mini-constitution, the Basic Law, what she described as their illegal occupation of parts of the city and fresh calls for people to rally.

Student leaders accused the government of using petty excuses to derail the talks and called for more people to occupy the streets, after numbers fell significantly following mass rallies that saw police fire tear gas on the crowds.

"When university students are willing to sacrifice their lives for democracy and fight against the ruling powers, you must realise how sick and oppressive the government must be to force students to make this decision," Alex Chow, leader of the Hong Kong Federation of Students, said after the government called off talks.

Hours earlier, Hong Kong's Justice Department handed to prosecutors the investigation into the business payout to Leung by an Australian engineering company.

Part of the brief includes "considering and deciding whether prosecution action is warranted" against Leung, who has refused to stand down in recent weeks over protesters' calls for Beijing to keep its promise of universal suffrage.

The department said its decision was aimed at avoiding "any possible perception of bias, partiality or improper influence".

The campaign against the former property surveyor and son of a policeman has extended from the streets to the city's legislative chambers, where democrats have threatened to veto major decisions and potentially cause policy paralysis.

Australia's Fairfax Media reported this week that engineering firm UGL Ltd paid Leung a total of US$6.4 million in 2012 and 2013 in relation to its acquisition of DTZ Holdings, a property consultant that employed Leung as its Asia Pacific director before he took office in July 2012.

Leung's office denied any wrongdoing. DTZ was not immediately available to comment, while UGL said it was under no obligation to disclose the agreement.

As part of the contract Leung signed with UGL in December 2011, he agreed to promote the "UGL Group and the DTZ Group as UGL may reasonably require, including but not limited to acting as a referee and adviser from time to time", according to a copy seen by Reuters.

Leung's office said in a statement that such assistance would only be provided in the event that he failed to be elected Hong Kong leader, and providing that such assistance would not create any conflict of interest.

Leung stepped down from DTZ on December 4, 2011, two days after signing the deal with UGL, which acquired the property consultancy. Leung was sworn in as Hong Kong chief executive in July 2012.

"After CY Leung became CE (chief executive), he should have terminated the contract, because as a CE, it was impossible for him to continue accepting huge payment to help promote UGL or DTZ," Democratic Party chief executive Lam Cheuk-ting said in a letter to the Independent Commission Against Corruption seen by Reuters.

"There's reason to believe that CY Leung was eyeing the unpaid remuneration by UGL so that he continued with the agreement. Even worse, since CY Leung honoured the agreement and accepted the payment, how could he not declare to the Executive Council?" said Lam, who is a former anti-graft agency official.

The ICAC said it did not comment on individual cases.

UGL said the agreement was simply a non-compete arrangement to ensure that Leung would not move to a competitor, set up or promote any business in competition with DTZ, or poach any people from DTZ.

Emily Lau, head of the Democratic Party, told Reuters it would try to form a select committee to investigate and possibly impeach Leung, although the formation of such a group would have to be backed by the entire 70-seat legislature and there was no guarantee that would happen, given the pro-Beijing majority.

Scenes of tear gas wafting between some of the world's most valuable buildings, violent clashes, mass disruptions to business and commuter chaos over the past 11 days have underscored the challenges Beijing faces in imposing its will on Hong Kong.

The protests have already caused a backlog in the former British colony's Legislative Council where scores of meetings have been cancelled.

China's Communist Party leaders rule Hong Kong through a"one country, two systems" formula which allows wide-ranging autonomy and freedoms not enjoyed on the mainland and specifies universal suffrage as an eventual goal. One of those freedoms is an independent judiciary.

But Beijing ruled on Aug 31 it would screen candidates who want to run for chief executive in 2017, which the democracy activists said rendered the universal suffrage concept meaningless.

Democratic lawmakers on Thursday threatened to veto some government funding applications, although none that affect people's daily lives, as they step up their civil disobedience campaign and try to paralyse government operations.

Protest numbers have dwindled to just a few hundred people at various sites around the city, but activists have managed to keep up their blockade of some major roads.

The Fairfax Media report does not suggest Leung committed any crime, although it raises questions about transparency.

It was not immediately clear why news of the payment came to light at this point, although the timing raises questions as to who may have raised the alarm.

Leung signed the deal with UGL in December 2011, two days before he stepped down as Asia Pacific director of DTZ, which is now a division of UGL.

He had already announced his plans to run for Hong Kong's top job, although his main rival, Henry Tang, was the presumed front-runner until he was tarnished by an illegal construction scandal and self-confessed marital infidelities.

An election committee stacked with Beijing loyalists chose Leung as leader in March 2012 and he was sworn in on July 1.

Leung's company, CY Leung & Co, merged with DTZ in 2000. He was a key player in the company's expansion into China.

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